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January 16, 2014

Best & Worst States for Fiscal Health

Mercatus Center’s new ranking takes a nuanced view of state fiscal conditions

Alaska, South Dakota, North Dakota, Nebraska and Wyoming rank highest in terms of fiscal solvency, but few will be surprised that New Jersey, Connecticut, Illinois, Massachusetts and California have a lot of work to do to shore up their finances.

Those latter five states are often the subject of news stories about budget deficits or unfunded pension liabilities.

Yet those headlines reveal just a segment of a state’s overall fiscal condition — something the Mercatus Center, a free-market oriented research center at George Mason University, seeks to correct through an improved state ranking that functions almost like a credit rating from Standard & Poor’s.

The author of the state solvency study, Dr. Sarah Arnett, an analyst at the Government Accountability Office, used four broad measures to assess a state’s fiscal condition.

From nearer to longer term, Arnett considered a state’s cash solvency, or the ability to pay immediate bills; its budget solvency, revenue sufficient to cover expenditures over a fiscal year; long-run solvency, which tracks all obligations over time, including pensions and infrastructure; and service-level solvency, the broadest measure, which looks at the ability of a state to provide the population’s health and welfare needs currently and long term.

In the short term, most states have sufficient liquidity to pay current obligations. While short-term funding isn’t a typical headline concern, by the standard corporate treasurers use in evaluating liquidity — the so-called quick ratio — 15 of the 50 states do not have what is considered to be adequate cash reserves. Illinois is in the worst short-term shape, followed by California and Connecticut.

A similar number of states, 16, fall short on operating ratios and budget deficits or surpluses, the key criteria used to determine a state’s ability to cover budget expenses over a year with that year’s revenue. New Jersey is in the worst shape from a budgetary point of view, followed by Delaware and West Virginia.

Arnett looks at three key ratios to measure long-run solvency — a subject that gets a lot of press as a result of underfunded public pensions. Arnett cites data from S&P suggesting that pension funding, on average across the states, has declined each year from 2008 through 2011, and she cautions that some states may neglect long-term liabilities in order to meet current budgetary needs — which is why the report focuses on multiple fiscal yardsticks.

New Jersey and Illinois lead the list of states whose long-run solvency is most at risk. The former has underfunded pensions and retiree health benefits. Second-worst Illinois has the same problem, but has compounded it by issuing long-term bonds to meet current annual pension contributions.

Altogether, a majority of 39 states have inadequate long-term solvency rankings. It is noteworthy, and Arnett notes it, that the best-performing state in terms of long-term solvency, Nebraska, is constitutionally prohibited from incurring debt.

The Mercatus report suggests that service-level solvency is the hardest to measure, but Arnett uses tax per capita, revenue per capita and expense per capita to capture the state’s ability to meet its population’s demand for services.

The fact that Alaska ranks as least solvent here illustrates the difficulty in measuring service-level solvency. With neither a personal income tax nor sales tax, Alaska’s ability to access revenue to pay for services would appear to be impaired. And yet, Arnett points out that a 0% rate also implies flexibility in raising such taxes if needed.

Exactly half the states show a less than adequate service-level solvency, with North Dakota and Wyoming following Alaska as most constrained.

That is because states like New Jersey and Illinois are at the bottom mainly because of poor financial management. In contrast, California remains at the bottom because of poor economic conditions and as a legacy of past mismanagement, though it is now improving its fiscal condition after years during which the gridlocked state was unable to produce balanced budgets or raise revenue.

Overall, just 18 states are in reasonable fiscal condition, whereas the budgetary and liability issues of 32 others require repair. Interestingly, Arnett found her study to track positively with the ratings S&P uses to assess states’ credit.